Recently introduced Washington House Bill 1111 and its Senate counterpart, Senate Bill 5294, would add Washington to the list of states with so-called "constituency statutes." If adopted, these bills will significantly change the standards of conduct that apply to directors of corporations organized in the State of Washington.

This Update outlines key issues raised by these bills.

Current Washington Director Conduct Standards

Section 23B.08.300 of the Washington Business Corporation Act, which follows the Model Business Corporation Act, establishes the standards of conduct for directors of Washington corporations – in short, to act:

• in good faith,
• with the care an ordinarily prudent person would take in similar circumstances, and
• in a manner reasonably believed to be in the best interests of the corporation.

Neither the Model Business Corporation Act nor the Delaware General Corporation Law contains a constituency statute.

Background on Constituency Statutes

States Adopted Constituency Statutes in Reaction to Revlon. Approximately 30 states have constituency statutes. States began adopting constituency statutes following the takeover heyday of the late 1980s, mainly in reaction to case law in Delaware that established the duty of a board of directors in considering either an acquisition of the company for cash or one that would result in a "change of control." Court decisions, such as in the Revlon case, articulate a duty for directors to obtain the best available value for the company's shareholders. Because the shareholders would cease to have a continuing interest in the company following a cash acquisition, Delaware courts have held that the board of directors must focus on the immediate short-term value of the company to its shareholders, rather than potential long-term values that the company may achieve.

Constituency statutes sought to alter the Delaware formulation of the duty of the board of directors in the Revlon case in two ways:

• by either requiring or (more commonly) permitting a board to take into account the impact of the transaction on constituencies – such as employees or the local community – other than the corporation's shareholders, and

• by requiring or permitting the board to take into account the shareholders' long-term as well as short-term interests.

While constituency statutes on the books in some states apply only in the takeover context, most apply in any circumstance.

Similar Bills Proposed in the Washington House and Senate

House Bill 1111 and Senate Bill 5294 would amend Section 23B.08.300 of the Washington Business Corporation Act. The proposed Washington legislation, if enacted into law, would permit (rather than mandate) a company's board of directors to consider constituencies or factors other than the interests of shareholders in making decisions. Like most other constituency statutes, it would apply to all director decisions, not just those involving a takeover. These bills expand the meaning of the phrase "in the best interests of the corporation" in the context of directors' standards of care by allowing (but not explicitly requiring) directors to consider a number of factors in addition to the interests of shareholders, including:

• interests of employees, customers, suppliers and creditors (the Senate Bill refers to "social, legal, economic, and environmental effects of" directors' decisions on employees, customers and suppliers);

• the national and state economies; and
• the impact of directors' decisions on communities in which the corporation or its subsidiaries have offices or operations.

The bills also permit directors to consider shareholders' long-term interests, in addition to their short-term interests, including (under the House version) "the possibility that these interests may be best served by the continued independence of the corporation."

Constituency Statutes – Good or Bad?

In this era of shareholder primacy and intense focus on corporate governance, these bills, if ultimately adopted, will interest governance watchdogs, large institutional investors who own shares in companies incorporated in Washington and other institutional shareholder organizations, such as Institutional Shareholder Services (ISS). As some Washington public companies have already seen with the Washington Takeover Act, the existence of a constituency statute in the Washington Business Corporation Act may become a negative factor in ISS's and institutional shareholders organizations' governance report cards. It remains to be seen whether incumbent management will welcome adoption of a constituency statute or institutional shareholder pressures will drive more Washington public companies to reincorporate to Delaware or other jurisdictions without constituency statutes.

House Bill 1111 and Senate Bill 5294, in their current form, raise a number of other interesting questions.

• Can corporations really be said to have "interests" apart from the interests of shareholders?

• How do directors reconcile the interests of shareholders and those of the company's other constituencies?
• May a board properly determine that any of the additional interests or factors described in these bills take precedence over the interests of shareholders? Should they?
• Will the business judgment rule protect a board's decision to consider other constituencies . . . or to ignore them?
• What is a board's basic duty when considering a sale of the company for cash, or a sale involving a "change of control"? Does the duty to maximize shareholder value articulated in the Revloncase remain valid?
• Do constituencies, such as employees, customers, suppliers, creditors or communities, have standing to bring a lawsuit against directors on the basis that a board allegedly failed to properly consider these parties' interests?

The Washington Legislature will grapple with these and other questions as it considers these bills, and we will monitor its progress.

Additional Information

You can find a copy of the full text of House Bill 1111 at http://lawfilesext.leg.wa.gov/biennium/2011-12/Pdf/Bills/House%20Bills/1111.pdf. You can find a copy of the full text of Senate Bill 5294 at http://apps.leg.wa.gov/billinfo/summary.aspx?bill=5294. You can find discussion of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.